8/10/2009 @ 5:30PM

Playing The Ratings Game

The possibility for substantive change in the ratings agency world has grown stronger, especially now that the Senate has a bill to review that will challenge how such firms do business. The flipside of this, though, is that it’s possible that by the time the final language of this bill is put before President Obama it will be somewhat toothless, offering to pass a patchwork of protections but leaving the fundamental problem of how the major ratings agencies operate untouched.

First some background. The bill, introduced May 19, is called the Rating Accountability and Transparency Enhancement Act of 2009, which forms the nifty acronym RATE. The sponsor is Sen. Jack Reed, D-R.I., the chairman of the Banking Subcommittee on Securities, Insurance and Investment. Currently the bill has been referred to committee, but has not been voted upon by the Senate or House.

On its face the bill contains some fairly strong language, pointed at the major ratings agencies: Fitch Ratings,
Moody’s
Investor Services, Standard & Poor’s Ratings Services (owned by The
McGraw-Hill
Companies) and A.M. Best. Reed says the new legislation would give the Securities and Exchange Commission new authority to oversee ratings firms, and hold them accountable for conflicts of interest. The bill also opens the door for investors to sue such firms for “knowingly or recklessly” failing to review key info during the ratings process.

Together these ratings agencies, among others, are called Nationally Recognized Statistical Ratings Organizations, meaning that they are registered with the Securities and Exchange Commission. This designation provides a semi-official gloss to their mission, which can be a problem, according to Martin Weiss.

Weiss is chairman of the The Weiss Group and has a long history in the ratings game. He began his own ratings firm Weiss Research in 1986, and by 1994 the Government Accountability Office had declared the firm’s ratings three times more accurate than those of A.M. Best, S&P’s and Duff and Phelps (now Fitch). He sold the firm in 2006 to the
TheStreet.com
, and today has no direct involvement in, or revenue from, rating firms.

Speaking today, the problem Weiss sees with the current legislation is that despite having some tough-sounding language the bill fails to address the single largest conflict of interest bedeviling the ratings world: that ratings agencies are directly paid by the firms they rate. To Weiss, however, this comes as no surprise, as he first testified before Congress about this same issue in 1991 and it has yet to change. Add in the fact that the NRSROs look government sanctioned and it creates a formula for what Weiss calls “grade inflation” among all securities rated, which he says “is driven by the fundamental conflict of interest that the ratings are bought and paid for by the issuers.”

Weiss, who has provided input to Reed on the bill’s language, says that one danger is that unless these conflicts of interest are removed they are bound to be responsible for massive losses for investors in the years ahead, as the inflated ratings are brought down to earth in a hurry as the ratings firms play “catch up” with reality.

It’s entirely possible, Weiss says, that the new legislation could end up eerily similar in result to the $1.4 billion 2003 Global Settlement of Conflicts of Interest Between Research and Investment Banking, where 10 firms, including
Citigroup
,
Credit Suisse
First Boston,
Goldman Sachs
and
JPMorgan Chase
, which failed to require a definitive split between research and investment banking. In lieu of that, it was mandated that stronger “Chinese Walls” be put in place. While some improvements were put in place due to this, he says, a more aggressive approach would have worn better over the years.

The evidence is there that when left to their own devices, ratings agencies succumb to the obvious temptations of being paid by the firms they rate. In July 2007, the SEC issued the results of its “Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Ratings Agencies,” which examined the practices of Fitch, Moody’s and S&P from January 2004 until the report was issued. Among other things the SEC found that when it came to collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBS)–major components of the subprime crisis–the agencies were lax in their vigilance.

Specifically the SEC found that these firms often failed to document important steps in their ratings process, were understaffed, would deviate from their ratings models, and that none of these firms had specific, written procedures for rating these sophisticated instruments.

Perhaps unsurprisingly the ratings agencies are in no hurry to change their models. Testifying before Congress on Aug. 5, Stephen W. Joynt, the chief executive of Fitch Ratings, said the conflicts of interest in the “issuer pays” model have been managed through a range of policies, including separating business development from credit analysis, and not allowing those employees who assign ratings to handle fees or discuss fees with issuers.

A.M. Best adds that issuer pays models allow the broadest dissemination of information, at no cost to the public. A Moody’s spokesman declined comment, but passed along firm documents that say the firm is bolstering measures to avoid conflicts of interest, including, the conduct of reviews of related ratings when an analyst leaves the firm, and keeping analyst from being compensated based on the performance of their unit. An S&P spokesman declined comment.

Despite the positive spin from the firms, other industry observers remain skeptical about the model ratings agencies have evolved. Ken Shubin Stein, the head of hedge fund Spencer Capital, agrees with Weiss that the marketplace can sort through the problems in the ratings agency world if Congress opens up the system and give its official seal to more firms with less obvious conflicts.

“These are companies that had legislated competitive advantages,” he said. “But because of these conflicts and because of greed they prostituted themselves. They sold their seal of approval to the highest bidder.” One notable exception, he says, is the Egan-Jones Rating Company, which is paid by the client, not issuer, side.

Playing The Ratings Game

Forbes: Let’s talk about restrictions on rating agencies. And this is a question for Martin. You said the conflicted business model, the nationally recognized statistically ratings or innovations, especially Fitch’s, Moody’s and S&P have not changed. And these firms are bound to be responsible for more shocking losses for investors in the years ahead.

You’re currently helping address some of this new legislation affecting these agencies. Let’s talk about it. Martin, what changes will your legislation put in place? And open questions for all, how will these changes, should they be implemented, impact investors? And what, if the current model is left as it is, what sort of losses can we expect going forward?

Weiss: Correct. We’ve seen losses primarily in the structured mortgages and other securities. The big losses I think investors will see in the future is when there’s an eureka moment in the rating agencies. And they announce massive, across the board changes in their rating scales. Or massive, across the board downgrades.

And as we all know, when a bond or a security is downgraded, then its price naturally has to reflect that change. Now some of that price decline will happen in anticipation of the downgrade. In other words, the market itself will force it that way. But you may see a more shocking development, what we call Friday night massacres. In which they announce a whole bunch of downgrades all at once.

S&P and Moody’s have already hinted that there are going to be hundreds of billions of dollars worth of corporate bonds that are going to be downgraded. But I think even they are underestimating the magnitude of this, because of the tremendous amount of grade inflation we’ve seen over the years that has to be corrected.

The grade inflation is driven by the fundamental conflict of interest that the ratings are bought and paid for by the issuers. The legislation that’s coming is to better, to kind of patch over these problems by bringing it under the auspices of the SEC and having SEC examiners effectively monitor these conflicts of interest.

And the input I’m providing to legislation is effectively saying that, No. 1, the conflicts and the biases are so deeply rooted in the business model that unless you change or at least encourage change in the business model, there’s no amount of regulation that’s going to fix the problem. And those problems are just so egregious, it would be very difficult to protect the public or the financial system without a fundamental reform in the business model itself.

Ken Shubin Stein: You know, it’s one of the most fascinating case studies in American history, I think. If you think about it. And I completely, 100% agree with Martin. That if we think about this, these are companies that had legislated competitive advantages. High returns on capital and significant growth prospects both because of inflation and because of transaction and deal volume accelerating. They were the perfect businesses.

But because of these conflicts and because of greed, they prostituted themselves. They sold their seal of approve to the highest bidder. Which became the, you know, structured finance parts of these businesses. And every single one of them, except Egan-Jones, which is paid by the client side, has just prostituted themselves and done a horrible disservice to their owners and to the American public.

And it’s just amazing as a case study for business school, it’s incredible that, just like everything else, incentives drive behavior. And in this case, the incentives of being paid for by the client, I mean by the corporate side, which as Martin’s pointing out, creates these unaccountable conflicts of interest that can’t be resolved in any reasonable way except to remove the conflicts.

Weiss: As my point to the drafters of the legislation is that in the absence of fundamental reforms, the close supervision and the strict enforcement that you would need to offset this conflicted business model would be either two burdens for the research organizations. And/or it would be inadequate to protect the public.

And so the new rules and legislation have to require or at least encourage fundamental reforms in the business model. And unless they do, they’re unlikely to succeed ultimately. And there are ways of doing this. First of all, these organizations have had the official sanction of the U.S. government. So there you have the most conflicted, egregious business models that are given, effectively, the seal of approval by the U.S. Congress.

And that was a designation of being an NRFRO, the Nationally Recognized Fiscal Rating Organization. So going forward, number one, the SEC or whoever is in charge of this, it would probably be the SEC, needs to open a clear path and a clear procedure for or research organizations, rating organizations, to gain a similar status. And that has not been the case. Egan-Jones is one of the very few. But it’s a very, very difficult and unclear process.

Shubin Stein: You know, Martin, don’t you think this is one of the cases where hedge funds and short sellers really significantly helped by being very early in the story and telling the public that this is a flawed and corrupt part of American corporate finance?

Weiss: Yes. We did the same, with Weiss research and Weiss ratings, without their publicly saying it. But I think they listened to the hedge funds a little bit more closely. And I testified on this subject 20 years ago. Unfortunately, nothing was done.

Shubin Stein: Obviously they didn’t listen closely enough.

Weiss: When they opened this approval process, then any new rating agencies that joined the group should, if they have a conflicted business model, they simply should not pass the test. It just doesn’t pass the smell test.

Forbes: No, it doesn’t.

Weiss: I mean, we know with Consumer Reports, Weiss Ratings, our organization and many others, we abide by the basic rule that we don’t accept a penny from the company or the issuer that we’re rating. In any form. And if any of our employees were to so much as accept a free lunch, they are subject to immediate dismissal.

Shubin Stein: Well, and this is, I think one of the points you made that’s so important for everybody to remember is this year’s been a closed system. Congress has only allowed a few firms to have the NRFRO seal of approval. And I agree with you 100%, Martin, that it needs to be an open process. And it needs to be an open, unbiased process so new competitors can come in. And, you know, firms like yours and firms like Egan-Jones play an essential role in what’s otherwise a completely corrupt system in terms of thinking about credit.

Weiss: My proposal is that legislation has to have that opportunity for new entrants. And any new entrants must not be conflicted. If they are, they simply fail the test. And for existing organizations that, you know, I don’t it’s realistic to expect Congress to shut them down. Or force them to change their business model.

Shubin Stein: But the marketplace will force change.

Weiss: The marketplace will. And there is no reason for the U.S. government to continue giving the conflicted ratings organization. If they want to continue their business model, that’s their business. And they’re welcome to do so. But at a certain point in the time, in the not too distant future, they should effectively lose their NRFRO designation. And that sanction of Congress.

Margaret Starner: Isn’t it sort of interesting, though, that nothing has really happened to them yet?

Weiss: With all that’s been revealed.

Starner: Yeah. I mean, I find that, as a layperson, a little shocking.

Weiss: Well, it is. And the average person, when they hear that these ratings are actually bought and paid for by the issuers, they’re shocked.

Starner: Well, I would say that we all knew that. And there’ve been a lot of complaints about that for many, many years.

Weiss: Professionals have known. But the average investor was not aware. And when they bought insurance policies that were rated by AM Best, or they bought corporate bonds or municipal bonds that were rated by Moody’s, most people didn’t realize or were not aware of the conflicts. Or were not aware that the conflicts were really having much of an impact.

Forbes: I’d go a step further. In that many top ranking professionals themselves didn’t quite understand what this meant. I interviewed Ace Greenberg, pre-interviewed him for the Steve Forbes show. And he said, basically, how did this happen? And he said, well, we believe the ratings agencies. You know, “We won’t do that again.” That’s what he said at the time.

Starner: I don’t believe that one bit.

Weiss: They said the same thing. They said the same thing with Enron. They said the same thing going back many years. There’s Baldwin United. One of the major insurance company failures in the mid 1980s. They said, “Oh, we believe the rating agencies won’t make that mistake again.” Quote, unquote. And they went ahead and made that mistake again and again and again and again.

Shubin Stein: You know, one of the things that makes this so insulting, particularly the retail, one of the reasons this infuriates retail investors, and just the average American citizen, is that these companies had a quasi seal of approval from the U.S. Congress.

Weiss: Yes.

Shubin Stein: And that’s just unconscionable.

Forbes: Why was the system so closed? Why did Congress say it is this small handful of firms and closed the loop to competition that could’ve made it more efficient?

Weiss: Lobbying power. And also, it’s not just the rating agencies, remember the bigger beneficiaries are the issuers of credit and the insurance companies. They get the seal of approval from A.M. Best or from Moody’s that says that they’re an A-plus-plus company. Or a triple-A company, depending on the rating scale. And they go out and they sell insurance up to the gazoo. And under that umbrella of, quote, unquote, “top notch safety,” they have the opportunity also to market some very aggressive, high-yield products.

Before it was junk bonds, junk bond based annuities. And now, in the most recent round, it’s been all these structured mortgage securities that underlined some higher yielding products. I mean, every investment salesman on Wall Street dreams about a scenario in which he or she can say this product is safe. And at the same time, say we’re going to give you a much better return than you can get anywhere else.

And we all know that the higher the yield, the greater the risk. But when a salesman can get a hold of that double sales pitch, they go to town. And that’s essentially what this whole system of ratings and conflicts of interest has produced. It’s given companies and insurance companies and others the ability to market their products under a rubric of safety or seal of approval. And at the same time, attract people to high yields and high returns.

Starner: But it’s still shocking to me that there are no consequences so far in this whole thing.

Weiss: Well, Congress is working on consequences right now. But unfortunately, it’s all about more controls: More regulation. More enforcement. More monitoring. And that just gums up the system even worse.

Forbes: I have a bunch of follow-up questions. I’m going to direct these to Martin, but everyone’s free to answer. First is, so you’re helping, or at least getting your input into some of the new legislation, Martin. What stage is any of this at right now as far as new legislation?

Weiss: This is going to come in simultaneously with the regulatory reform overhaul. And it’s going to be attached to it. And there will be something on this area. Unfortunately, my fear is that it won’t be fundamental in nature. It will be more window dressing. The SEC global settlement had the same problem. The SEC global settlement which came out a few years ago was supposedly to remove conflicts of interest in some research analysts. And it did to some degree, but it really didn’t change the fundamental conflicts.

Forbes: Are we talking about the fall where this could start to be

Weiss: Well, actually, health is No. 1 on the agenda, but this is coming soon thereafter. And I don’t have any idea as to when it’s actually going to pass.